Fire Bernanke And Geithner, Kill "Too Big To Fail", And Make Banks Use Convertible Bonds To Bail Themselves Out...

Fund manager John Hussman (Hussman Funds) has been spot on in his criticisms of the Bernanke-Geithner Wall-Street-first bailout philosophy, as well as his outrage about how taxpayers have been shafted again and again to ensure that bondholders don't lose money.

Here, in a new essay, Hussman summarizes his plan to fix Wall Street and avoid future crises.

Hussman's financial reform plan is the best one we've read. Unlike others, it does not artificially restrict the size of US financial institutions, thus placing them at a competitive disadvantage against far-larger Chinese and European institutions that are beyond our regulatory control. Instead, it just creates a way for these institutions to "fail" without hurting the system.

The reprieve of recent quarters may create a misleading impression that there is no urgency to the issues faced by the U.S. economy, but as noted below, the likelihood of fresh mortgage losses and credit difficulties is high. Few reforms have been enacted that would make a second wave of difficulties any different from the first. The following would provide the U.S. with broader policy options. To the extent that these points are consistent with your own views, feel free to forward it to others, including representatives in the House and Senate . It remains important to get this right sooner rather than later. The social cost of misallocating trillions of dollars is difficult to overstate. – JPH

1) Immediately vest the FDIC (or other regulator that has a strict consumer-protection mandate) with the authority to take receivership / conservatorship of distressed bank and non-bank financial institutions, including bank holding companies, in the event of insolvency.

It is essential for the public and policymakers to understand that the "failure" of a financial institution does not generally imply losses to customers or counterparties, but only to its stock and bondholders. The FDIC efficiently handles scores of bank "failures" annually by taking receivership or conservatorship of the whole bank, typically selling its assets and non-bondholder liabilities as a single going concern (which can then be recapitalized), wiping out stockholder equity, and providing partial recovery to bondholders with any residual. This receivership process works.

Bank failure through the receivership process - even involving major banks - does not create economic harm or even loss to depositors. Witness the seamless and almost forgettable receivership of Washington Mutual two years ago, which was the largest bank "failure" in history. We should not be devoting public funds to bail out such failures, outside of the receivership process. What should, and must be avoided are disorganized Lehman-style failures requiring piecemeal liquidation of going entities. This distinction is crucial. The disruption created by Lehman's disorganized failure need not have occurred if the FDIC had been vested with authority to take the going concern into receivership and to provide partial recovery to bondholders with the proceeds of Lehman's intact transfer.

2) Require a significant portion of the capital of bank and non-bank financial institutions to be in the form of convertible debt (contingent capital).

When the assets of a company decline below the value of its liabilities, the only buffer between solvency and bankruptcy in the present system is shareholder equity. For example, if a company has $100 of assets, $95 in liabilities and $5 of shareholder equity, a decline in the value of assets of anything over 5% will make the institution insolvent, even if a large proportion of those liabilities are to the company's own bondholders. This bondholder capital can only be accessed as a buffer against customer losses if the bonds default or "fail." Requiring a significant portion of bondholder capital to be in the form of convertible debt would avoid this problem. If the company approached or became insolvent, a portion of bondholder capital would undergo a mandatory and automatic conversion to equity, providing an additional buffer against losses to customers and counterparties, without requiring public funds, and without requiring bond defaults. This approach has also been proposed by William Dudley, president of the New York Federal Reserve.

Though a like provision is included in H.R. 4173, that bill also quietly provides the Treasury and Federal Reserve up to $4 trillion in bailout authority for the banking system, with recklessly thin restrictions (e.g. maximum Congressional debate of 10 hours in the event of future emergency funding requests). This provision should be stripped or made subject to drastically stronger oversight and restrictions on what constitutes emergency funding. Revisions should emphasize safeguards to ensure full recovery, implement repurchase provisions and other built-in exit strategies to extract government provided capital, and should subordinate both equity and bondholder claims to those of the government in the event of eventual default (preferred stock investments are inappropriate in this regard).

3) Abandon the misguided and dangerous notion of "too big to fail" by making regulatory receivership / conservatorship a credible threat, and encouraging insolvent financial institutions to exercise the option of voluntary debt-equity swaps as an alternative to regulatory intervention.

In virtually all cases, the liabilities of these companies to their own bondholders are capable of fully absorbing all losses without the need for public funds. This layer of bondholder capital is sufficiently thick that neither customers nor counterparties of the institution need be affected by the "failure" of major financial institutions. By providing public funds to defend the bondholders of these financial institutions, each dollar of debt that should be written off survives as two - one being the original dollar of debt, and the second being a new dollar of public debt that must be issued to finance the bailout. Presently, the bondholders of even Bear Stearns stand to receive every penny of principal, with interest, on their debt securities, thanks to the American public. This absurdity owes itself to the inability of the FDIC or other regulator to take Bear Stearns into receivership in 2008 - an inability that stunningly continues to exist because Congress has not acted to provide this authority.

4) Approve the Volcker Rule.

The abandonment of Glass-Steagall a decade ago has proved to be a massive and failed experiment, allowing financial institutions to conduct speculative activities with cheap credit, piggy-backing on banking protections that were designed strictly for the benefit of the public. Ideally, the Volcker rule should be extended to encompass the restrictions of the original Glass-Steagall Act (which was passed in 1933 following the Great Depression). The failure to separate the banking system from leveraged, non-banking activities such as underwriting and speculation creates countless interdependencies and implicit subsidies. It also creates difficulties in protecting bank depositors from losses without also inappropriately protecting counterparties to much more speculative activities. This lack of delineation has been a clear contributor to the difficulties that the U.S. economy now faces.